A proposal from the Obama administration to reduce the federal corporate tax rate has not generated as much enthusiasm among small business owners as might be expected. Small business advocates claim that the proposed reduction, while seemingly beneficial at first glance, would actually only help a small percentage of companies. The proposed reduction would lower the top corporate tax rate from thirty-five to twenty-eight percent. For manufacturers, the rate would top out at twenty-five percent. The problem is that the proposed reduction only applies to C corporations, the corporate structure used by most large businesses and very few small ones.
According to the Associated Press, only twenty-five percent of small businesses use the C corporation structure. Other small businesses are organized as S corporations, limited liability companies (LLC’s), partnerships, or sole proprietorships. The primary difference between a C corporation and a S corporation is the way in which they pay taxes. C corporations pay federal income taxes on net revenues, and shareholders pay taxes on dividends received from the corporation. This is sometimes known as “double taxation,” since the corporation and the shareholders both pay income tax on what is essentially the same money. In a S corporation, income “passes through” to the shareholders, who pay the income tax. Tax laws set specific restrictions on who can be a shareholder in a S corporation, and the total number of shareholders is capped.
Other types of businesses, like LLC’s and partnerships, also usually do “pass-through” taxation, although they may sometimes opt to pay tax like a C Corporation. Sole proprietorships are typically just a legal alter ego for the business owner, so taxes are paid through the individual’s tax return. According to the National Small Business Association, up to eighty-three percent of small businesses pay taxes at the level of the owner’s personal income.
While larger corporations may see a reduction in their taxes, small businesses may not see any change, or may even see an increase in some circumstances. The Wall Street Journal reports that people with total income of more than $250,000 per year will see an increase in their personal tax rates if the Bush tax cuts expire on schedule at the end of 2012. This would have the effect of raising the tax rate on small businesses whose taxes are tied to their owners. Several small business advocates quoted by the Wall Street Journal promote reducing the personal income tax rate along with the corporate rate in order to more effectively help small businesses and the self-employed.
The last time the expiration of the Bush tax cuts was up for debate, Bloomberg Businessweek reported on small businesses that were choosing the C corporation structure specifically to avoid a possible increase in tax rates. Nearly three years since that report was published, it is worth noting that the number of small businesses organized as C corporations remains relatively low. There are many advantages to small businesses in structures like S corporations or LLC’s, and federal income tax is only one factor for small business owners to consider.
The New York business attorneys at Samuel C. Berger, PC offer fixed-fee packages of legal services to businesses and entrepreneurs who want to do business in New York and northern New Jersey. To speak to a member of our skilled legal team, contact us today online or at (212) 380-8117.
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Photo credit: ‘Factory’ by Asif Akbar on stock.xchng.